By Tim Czmiel
The cost of inventory is increasing markedly—and not only because of rising interest rates. The war in Ukraine has impacted commodity markets and disrupted trade flows, inflaming an already troubled situation.
Additionally, the breadth and depth of sanctions aimed at punishing Russia are further disrupting global supply chains and adding immense uncertainty to capital markets. (The tally of FAQs about Russian sanctions on the website for the U.S. Treasury’s Office of Foreign Assets and Control stands at 1,030 as of April 26).
We spoke to a number of senior executives at major banks with international platforms for their informed views on the financing implications from first- and second-order effects of the war in Ukraine and sanctions against Russia, including a likely ban by the EU on Russian oil imports or a move by Russia to expand its own natural gas cut-off throughout Europe.
Noting that borrowers that used to keep 60-90 days of inventory are now keeping a 120-day or more stockpile, banks are experiencing a significant increase in outstandings. In essence, these banks’ corporate clients are utilizing their ability to draw down their lines of credit to maximize their available inventory (attempting to minimize their exposure to supply chain disruptions). A key concern by one banker with whom we spoke is the borrowers’ ability to pass through the additional inventory costs to their customers, affecting margins.
Furthermore, in-transit inventory—which has been typically deemed as eligible collateral to lenders (so long as FOB or BOL title has transferred)—is less financeable now as cargo ships wait for weeks to arrive into overcrowded ports with inadequate staffing and an already challenged supply chain of trucking options. This “drayage period” for the unloading and processing of cargo at the port of destination has increased from under thirty days to several months now, causing once eligible in-transit inventory to be disallowed as collateral by lenders. Extended delays at the Long Beach and Los Angeles ports led many businesses to move shipments to east coast ports, and although supply chains have improved somewhat, the drayage period is still elevated. Further cause of concern comes from the Chinese government’s COVID lockdown of Shanghai and the enormous number of container ships off-shore China waiting to load or unload. As a result of these supply chain disruptions, many borrowers are seeking longer in-transit eligibility periods and covenant waivers, while lenders are forced to weigh the consequences of increased risk exposure and loan defaults.
Credit facility balances are up, leaving smaller loan reserves available to borrowers. Bankers may feel pressure from borrowers to increase credit limits. But borrowers should expect that lenders will require an additional amount of subordinated debt or equity to meet their working capital needs. At a minimum, increased credit will come at a significantly higher interest rate. It may be necessary for borrowers to raise funds by issuing additional equity, resulting in dilution of ownership. One corporate executive told us that his company financed working capital using highly expensive equity because their lender refused to increase the credit limit on their revolver. The firm has since ordered a reevaluation of credit lines and is seeking alternative or supplemental banking representation.
For many corporate borrowers, this situation carries significant additional risk because of senior management’s inexperience in a comparable economic climate. A number of deeply experienced, executive-level bankers expressed concerns that a whole generation of CFOs have held these roles solely in a fiscal environment with plenty of liquidity, modest inflation and extremely low interest rates. This is in contrast to earlier times like the 1980s when CFOs were, for the most part, seasoned veterans who had managed through inflationary shocks, recessions and stagnant growth. Many of today’s CFOs (and financial advisors/interim managers, for that matter) simply do not have the experience to contend with volatile issues on many fronts, including skilled and non-skilled labor shortages and fractures in the supply chain.
In 2021, supply chain and labor issues resulted in lower margins, tighter liquidity and higher leverage for many companies. While there was widespread belief that conditions would improve in 2022, businesses are continuing to struggle, especially those with longer supply chains. Disruptions stemming from the Ukraine war will only exacerbate those difficulties. Consequently, borrowers are increasingly transitioning from cash flow and enterprise value-based loans to asset-backed loans, which often deliver more liquidity and less restrictive covenants.
To summarize, there is significant financial interdependency in global supply chain dynamics. The repercussions have only started to be felt in a wide range of industries. Companies that have sole-sourced parts may be forced to shut down facilities for an extended period of time, leading to further cash-flow issues and the risk of credit default. Borrowers would be prudent to heed our warning and work with a trusted advisor to get ahead of this worsening chain of events before it is too late.